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By Bert Dohmen
Bert Dohmen’s WELLINGTON LETTER 11-28-2010
In 1978 we had predicted that T-bond prices would decline by 40-50%, i.e. yields would soar, but Wall Street chuckled. Yet our forecast came true.
In 1981, we wrote in these pages that the T-bond market offered an opportunity of a life time. Yields on the 30-year were at 15 ¾%. It was a 100 year high in yields. Over the next years, T-bond prices soared as their yields plunged.
Some of the subscribers who were with us will remember that “opportunity of a lifetime.”
We were so sure that it was a bottom in T-bonds (top in yields) because it was a 100-year record combined with a great change in the economic environment. The long term inflation indicators had just broken their long term up trends. This suggested a long term decline in inflation.
Currently, our work suggests that we are near or at an all time low in T-bond yields. Never in history have these yields been lower. That doesn’t mean that bond yields will now soar. But they will move higher. A somewhat stronger economy next year would produce a giant top in T-bond prices (bottom in yields). Much depends on the policy changes in Washington.
We now have 2-year T-notes yielding about 1.5% with economic growth around 2%, and inflation probably twice as high, depending on how it’s measured. In other words, large companies and banks can now borrow money at rates below economic growth and below inflation. That’s known as “free money.” In normal times that’s usually very bullish for the markets and the economy. But these are not normal times.
Skeptics will say that we have had similar conditions, all during 2010. Yes, but we had a huge barrier to economic growth created by the Reid-Pelosi coalition. That barrier now has some big holes.
This brings opportunities, but also pitfalls for investors. Virtually all individual investors are now heavily exposed to the bond market. They will get hurt if bond price decline. If you want yield, high dividend paying stocks will be a better alternative. That would include the energy trusts. If the economy improves next year, they will appreciate nicely.
The sharp plunge in the muni-bond market over the past several weeks serves as a warning that money is now flowing out of bonds. Muni bonds are illiquid. They are bought as very long term holds. When these sleepy investors finally wake up and sell, you know there is a change in sentiment. Municipalities are in deep trouble. They won’t get bailed out by the Federal government. The only alternative for many is to file bankruptcy Chapter 9, which enables them to abrogate their contracts, such as pension obligations.
CONCLUSION: When the masses put their money into one sector for almost two years, as they did in bonds, and prices reach a historic record, it’s usually time for the markets to reverse. We would not own most bonds at this time, with a few exceptions.